If you’re investing in cryptocurrency, it’s important to know how these currencies – and any gains you earn from buying and selling them – are taxed. The IRS has issued guidance about reporting cryptocurrency transactions, which the agency refers to as “digital assets,” on income tax returns. Here’s what you need to know about filing taxes for cryptocurrency.
If you’re unclear about reporting cryptocurrency income, gains or losses, you may want to consult a financial advisor with cryptocurrency expertise.
Cryptocurrency Is Property
The IRS made it clear that cryptocurrency is treated as property for U.S. federal tax purposes in 2014’s Notice 2014-21. There is a large body of established tax principles and law for property that apply to cryptocurrency and how the gains, losses, income and transactions are treated for federal tax purposes.
Among other things, this means that a payment made using cryptocurrency is subject to information reporting to the same extent as any other payment made on property. Using cryptocurrency to pay independent contractors and other service providers is taxable, and self-employment tax rules generally apply. Using cryptocurrency to pay employees is also taxable to the employee, must be reported on a W-2 and is subject to federal income tax withholding and employment taxes. Certain third parties who settle payments made in cryptocurrency on behalf of merchants that accept cryptocurrency from their customers are required to report payments to those merchants on a 1099-K.
Investors should also note that the infrastructure bill passed by Congress in 2021 required digital currency brokers to send Form 1099-B to report cryptocurrency profits and losses annually. However, the IRS delayed this requirement in December 2022 “until final regulations are issued.”
Nevertheless, the IRS asks tax filers to answer on their tax returns whether they sold, exchanged, gifted or disposed of a digital asset or a financial interest in a digital asset at any time in tax year 2022 (which you will file in 2023).
Cryptocurrency Is a Capital Asset
Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. For examples, stocks and bonds, coin or stamp collections and precious metals are capital assets. For most, cryptocurrency will also be a capital asset.
Determine Your Crypto Capital Gains or Losses
The related gains and losses on the sale or exchange of virtual currencies would be considered capital and would be further classified as having short-term or long-term capital gains or losses. A gain or loss is deemed short term if it relates to an asset held for one year or less. A gain or loss is deemed long term for an asset held for longer than one year.
In this case, to figure if you held cryptocurrency longer than one year, start counting on the day following the day you acquired it. The day you disposed of the cryptocurrency is part of your holding period.
Know Your Capital Gains Tax Rate
The tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. The term “net capital gain” means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss. The lower rates that apply to net capital gains are called the maximum capital gains rates. For 2023, the maximum tax rates for individuals are 0%, 15%, 20% and up to 23.8% including the net investment income tax.
Report Cryptocurrency Sales and Exchanges on Form 1040
The information on a 1099-K reports the gross proceeds from the transactions involving cryptocurrency but does not provide the necessary details to determine any gains or losses on the transactions. For this, each person must separately compute his or her gains and losses. Each time you buy, sell, send and receive cryptocurrency needs to be properly categorized to determine the holding period, basis and price in U.S. dollars of the cryptocurrency transaction.
Furthermore, if you exchange one currency for another, this exchange is treated as a sale for tax purposes. For instance, if you exchange Bitcoin for Ether, this exchange is a taxable event. You will need to note the value of both coins in U.S. dollars on the day of the transaction to determine the associated gain or loss.
Transfers to and from your wallets are most likely not exchanges and therefore not taxable events. The variety of transfers and transactions requires detailed record-keeping and analysis of each transaction to determine whether it was a purchase, a sale or merely a transfer. Many exchanges allow you to download your transactions, which you then need to sort and analyze to determine the nature of each and which you need to report.
Keep Track of Transactions
It is strongly recommended that you keep detailed records of all your cryptocurrency transactions. In the absence of this analysis, the IRS assumes that the entire gross proceeds reported on a 1099-K are taxable, so it is crucial to analyze and report the cost basis and sales price properly.
Once you have analyzed your cryptocurrency transactions and determined the holding period, the cost basis and sale price, you need to report this information on Form 8949. Form 8949 has separate parts for short-term and long-term transactions. Short-term gains and losses are reported on Part I and long-term gains and losses are reported on Part II of Form 8949. These distinctions are essential to arrive at your net capital gain or loss, which you summarize and report on Schedule D.
Capital losses are allowed in full against capital gains plus up to $3,000 of ordinary income. Capital losses above $3,000 are carried forward and can offset your capital gains in subsequent years.
Hard Forks and Airdrops
In October 2019, the IRS released a revenue ruling concerning the treatment of two processes: “hard forks” and “airdrops.” Both processes involve new currencies which are derived from splitting off of old currencies.
According to the IRS’s statement, “A hard fork is unique to distributed ledger technology and occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. ”
Meanwhile, an airdrop “is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” A hard fork followed by an airdrop can lead to the creation of a new currency, but an airdrop doesn’t always come after a hard fork.
The creation of new currency is important, because, according to the new rules, taxpayers do not have income as a result of a hard fork if they do not receive units of a new cryptocurrency. They do have ordinary income if they receive units of a new cryptocurrency in an airdrop following a hard fork, which means it’s taxable.
That’s an awful lot of jargon, but suffice it to say that if you wind up with new units of a currency as a result of these processes, those units will qualify as taxable income.
Digital currency investors suffered losses in 2022 after multiple bankruptcies, liquidity issues and the collapse of the crypto exchange FTX. While some may be able to claim crypto losses on their taxes, others are required to report crypto-related income and gains.
Merchants accepting cryptocurrency from customers are required to report payments on a 1099-K. And while the IRS has delayed the 2021 rule from Congress, which requires digital currency brokers to report cryptocurrency profits and losses on a 1099-B form, the agency asks tax filers to disclose taxable income, gains and losses from digital assets on their returns.
Tips for Alternative Investments
- Before incorporating alternative investments like cryptocurrency into your portfolio, it’s a good idea to consult with a financial advisor who can make you aware of the risks. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Another alternative investment that could play an interesting role in your portfolio is real estate. Investing in real estate can take many forms, from buying into an REIT through your broker to buying property and renting it out. Once again, it’s a good idea to consult with a financial advisor to make sure you’re doing it right.
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